THE UNACKNOWLEDGED ORIGINS OF THE BANKING CRISIS, PLUS TEN MORE INSIGHTS

How long do crises last? Are more bank failures to come? How did the current crisis unfold? And more...

In the following interview, which has been edited for brevity, clarity and flow, John Maxfield answers questions that bear on the severity and duration of the current banking crisis which has already yielded three of the four biggest bank failures in history.

Jonathan Rowe: Three banks have failed since the beginning of the year, and one has gone into voluntary liquidation. People are calling this a crisis. Do you agree with that?

John Maxfield: Crises come in all shapes and sizes. Since the beginning of the country, we've experienced nine major banking crises, or panics, and a couple dozen minor ones. It seems like there should be a clear definition of what these are, but there isn’t. If you go through the literature, you’ll find different scholars defining these in different ways. Some use the stock market as a barometer. Others use bank failures. But stocks can fall and banks can fail outside of the context of a crisis. What I would say differentiates a crisis or panic from ordinary times is less objective. It has more to do with widescale irrationality that manifests itself in indiscriminate bank runs.

JR: Is it fair to use the words crisis and panic interchangeably?

JM: Yes and no. You can have a crisis without a panic but not a panic without a crisis. A panic is a short, punctuated moment within a crisis, which is otherwise dominated by long periods of anxious anticipation that other shoes could drop. We're in a crisis right now, for instance, but not a panic. The panic ended when the government stepped in to stop the bank runs at Silicon Valley Bank, Signature Bank and First Republic Bank.

JR: Take us through the chronology of the crisis, from when it originated to today.

JM: The seeds for the crisis were planted in 2020 and 2021, when the Federal Reserve and executive branch flooded the economy with monetary and fiscal stimulus, throwing it out of equilibrium.

The crisis began two years later.

Most people identify the start of the crisis with Silvergate Bank’s decision to liquidate, which it announced on March 8, 2023, after losing 70 percent of its deposits in a bank run. Where the crisis really started, however, was with Provident Bancorp, or BankProv, a 195-year-old bank based in Massachusetts that wrote off or otherwise jettisoned $80 million out of $120 million worth of digital asset loans, including $50 million in loans secured by cryptocurrency mining rigs. BankProv didn’t fail, but it was the canary in the coal mine.

JR: Why is it that banks are so vulnerable in moments like this?

JM: The thing to appreciate about banks is that they are fragile institutions. This is intentional.

The primary constraint most businesses face is scarcity — scarcity of demand, supply and labor. Not so with banking. In banking, the primary constraint is abundance. This follows from the fact that, for all intents and purposes, there is no limit to the quantity of raw materials that a bank can temporarily arbitrage. It can go into the money markets and buy all the money it needs and then turn around and lend all that money so long as it’s willing to do so on lenient terms.

This puts the onus on the people who run banks to throttle their own growth, which isn’t something humans are designed to do. Most of us want to maximize short-term profits, even if, as is often the case, that comes at the expense of long-term solvency. A bird in the hand is better than two in the bush.

Banks are also unusually susceptible to the consequences of errors previously committed. Take Washington Mutual, the biggest bank failure in the history of the United States. When it failed in 2008, its non-performing loan ratio was only 3.5 percent. It got a 96.5 percent on its test in other words yet still failed the class.

Banks are highly leveraged institutions. They borrow $9 for every $1 worth of capital. If the assets on a bank's balance sheet decline in value by even 10 percent, in turn, it will wipe the bank out. And it isn’t just the amount of leverage that matters, it’s also the type. Deposits are by and large God’s gift to banks given how cheap and stable they tend to be under most circumstances. But the catch is that they can be withdrawn at the discretion of depositors, which becomes an existential threat if many depositors do so at once.

JR: Almost as if everything's fine until it isn't.

JM: That's right. When you go back through time, you can chart out individual institutions that have failed or succeeded, and one of the things you find is that there is a similarity of shape of all these curves. The ones that have succeeded and the ones that have failed. And to your point about everything is fine until it isn't, what you find in banking is that you'll have these curves climb over an extended period as a bank grows, and then, suddenly, it just goes straight down. To your point, everything is fine until it isn't.

JR: A lot of bank executives are probably digging into their balance sheets right now and trying to think through all of this. What will separate strong banks in times like these from weak banks?

JM: Banks rarely fail because of decisions made during a crisis. They fail instead from decisions made in the final years before a crisis. So that’s the differentiating factor. In Silicon Valley Bank’s case, it was decisions made in 2020-21 to allocate $70 billion in surge deposits to long-dated mortgage-backed securities, which declined in value when interest rates rose in 2022. In Signature Bank’s case, it was a byproduct of cryptocurrency exposure as well as a festering relationship with regulators. In First Republic Bank’s case, it was the years’ long habit to underprice loans and overpay for deposits.

JR: Do you think there are more failures to come?

JM: Never say never. If long-term rates remain lower than short-term rates, there are likely to be banks that fail because their earning assets produce less interest income than they have to pay in net interest expense to fund those assets. Beyond that, given what seems to be an impending, if not already-begun, recession, there is always the possibility that banks could succumb to credit losses.

JR: Historically, when bank runs happen, do they subside over time?

JM: The best way to think about it is that the banking system is a system in unstable equilibrium. The difference between a stable equilibrium and an unstable equilibrium is that when an unstable equilibrium goes out of equilibrium, it does so at an accelerating rate — the further out, the faster it goes. It's like nuclear fission, not dominoes. In the case of bank runs, for instance, one plus one plus one doesn’t equal three, it equals eight in term of the effect on the psyche of depositors. Left of their own, in turn, banking crises can continue for years, as was the case in the early 1930s. Nowadays, however, policymakers at the Federal Reserve and other regulatory agencies have a wide array of tools to shorten crises, which they liberally use.

JR: Looking at this again through the lens of history, are there benefits to a banking crisis? You know, and obviously, when you bring up something like the depression, again, you instinctually think it was a terrible thing, but is there a flipside to this?

JM: This is a terrific question because few people think about it like that. I happen to think that crises are a net good for societies that value growth.

Here’s an example. In the mid-1800s, Jay Cooke was the banker of the era. It was Cooke who sold the bonds that financed the Union Army’s defeat of the Confederates in the Civil War. After the war, Cooke was enlisted by the government to help shore up the country’s northern border against British encroachment by financing the Northern Pacific. So he loads up his bank with Northern Pacific bonds. These plummet in value in 1873 and cause his bank to fail, triggering the Panic of 1873 and a multiyear economic depression.

The Panic of 1873 wouldn't have been fun to live through, but when you consider that the United States controls Washington, Idaho, Montana and North Dakota, thanks in no small part to the Northern Pacific, which was eventually completed, it’s hard to deny that it was worth it.

More generally, the evidence suggests to me that the gains on the upswing of cycles tend to exceed what’s lost in the downswings.

JR: How long do crises like this ordinarily last?

JM: The primary variable that dictates the duration of a crisis is whether it’s a credit- or liquidity-induced crisis. Crises that are preceded by lending orgies parlay into periods of deleveraging which can last for years. That was the case in the Great Depression and the financial crisis of 2008, both of which took upwards of a decade to recover from. Alternatively, the panic of 1884 and the crisis in the early 1920s were primarily liquidity induced — asset prices inflated as a result of excess equity, not debt. These tend to be much shorter because they’re not followed by a period of deleveraging. I’d argue that the present crisis is of the latter variety, triggered, as we’ve discussed, by the tsunami of cash dumped on banks from fiscal and monetary stimulus.

JR: If you're a bank investor, how do you navigate or think about this crisis?

JM: If you’re a bank investor with money to invest, there is nothing better than a banking crisis. The thing about bank investing is that a good bank will earn 12-14 percent on its equity year in and year out. That’s effectively the ceiling. You're never going to get the explosive growth that, say, a tech company experiences. The only way to juice your returns, then, is to pay a low price for the stock. If you pay one times book value for a bank that earns 12 percent on its equity, then you’ll earn 12 percent on yours, but if you pay half of book value you’ll earn 24 percent on your original investment, holding all else equal. The trick is to be patient enough to wait for these moments and then courageous enough to put your money to work when everyone else is paralyzed by fear.

JR: That's great perspective, John. For anyone looking for more research, insights and articles like this you can subscribe to Maxfield on Banks at maxfieldonbanks.com.